The Contagion Effect: Macroeconomic Risks in United States and Europe

Posted in Finance Articles, Total Reads: 4430
, Published on 19 February 2014

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Risk is generally associated with uncertainty concerning the occurrence of a loss. It’s a possibility of deviation from the expected outcome. The impact of a risk is felt globally these days in an increasingly interconnected world. One may use the term ‘contagion effect’ to define this phenomenon more precisely. It is observed every time when a reaction at one place has repercussions for another. Risks emanating at one place present problems that are global and require global solutions. This phenomenon came into play very recently during the Financial Crisis of 2007-2008, where the risk originated in the United States but its impact was felt throughout the world. These risks are systemic in nature i.e. they have a cascading effect which has the potential to bring down not one individual entity but the entire system or market. Hence, it is of utmost importance for an economy to identify such risks and to develop risk mitigation measures in order to lessen their impact.

image:potowizard, freedigitalphotos.net

The World Economic Forum in its latest report titled ‘Global Risks 2014’ has identified ten global risks of highest concern. For the purpose of this write-up, we would like to dwell on the top two-

1) Fiscal Crisis in key economies

2) Structural Unemployment/Underemployment

Here, we are dealing with macroeconomic risks, such risks are perceived as the ones which are most interconnected with other risks, and have implications for the society as a whole.

Fiscal Crisis in Key Economies

An economy works on the basic principle of paying for its expenses through what it earns from the money of its taxpayers. A fiscal imbalance occurs when the economy’s expenses overshoots what it earns from taxes. The equation in the real world is not so simple, as taxpayers’ money is usually not enough to finance an economy’s expenditure. Hence, it resorts to issuing bonds or loans to investors to finance its expenditure. The economy enters a crisis mode when it is already servicing a huge debt, and is no longer able to pay the promised returns back to investors. This creates the aforementioned fiscal imbalance, and a worsening fiscal imbalance might lead to a default. The economy fails to finance activities such as providing social services, defence payments and other regular government activities.

On Oct 1st, 2013, after the U.S. couldn’t pass a resolution to fund government debt, several National Parks, historical sites including The Lincoln Memorial were closed to the general public.

As we can see from Figure 1, point P1 is where the Government Income (from taxation) is equal to the Government Expenditure. A fiscal crisis occurs when the balance starts shifting more towards the area shaded in red.

Figure 2

Figure 2 illustrates the consequences, of a scenario where the United States defaults on its debt

The point under consideration here is how exactly a risk of sovereign default in one economy would spread to others. This leads us to the concept of what might be referred to as ‘fiscal discrimination’. Investors are always on the prowl for finding good investment destinations which not only offer a good return on their investment but also exude the confidence of actually meeting this obligation. They are quick in moving their money around the world, and their decisions are usually based on market cues. Hence, if investors see the possibility of a loss, they’ll suddenly start clamouring to identify more trouble, looking for similar traits around the world. They might start pulling funds out of an economy which is nowhere near a sovereign default but is sending out the same cues as the one which just defaulted. This mass exodus of money sends out a panic signal which reverberates across the world, sending financial markets into turmoil.

In 2010, the economic crisis of Greece became Europe’s nightmare as investors suddenly started denying Portugal, Ireland, Italy and Spain favourable interest rates. This eventually led to fissures in these economies being exposed at a later stage.

It certainly is an unpredictable phenomenon where all of a sudden people get to find out that the funds which they believed existed suddenly stopped to exist. What ensues is complete financial disarray.

A certain kind of crisis can quickly transform into another one. An economy’s domestic banks hold a significant amount of government bonds; a sovereign default leads these banks towards insolvency, effectively turning a fiscal crisis into a financial crisis.

Structural Unemployment/Underemployment

Unemployment is one of the most detrimental factors that affect the society as a whole. The longer a person stays unemployed, the harder it is for him/her to get back to work. It’s a peril which leads to discouragement, disappointment, societal segregation and in most extreme cases to higher crime rate and broader societal unrest.

Structural unemployment is another interesting aspect which presents unique problems of its own. It results from a skill mismatch, which means that the jobs present in an economy require a skillset not present in the available workforce. This phenomenon is depicted by Figure 3. Another reason for its existence might be a radical shift in an economy in the long term.

In the last 20 years, Car Production in the UK has gone down drastically as these jobs have moved to the Far East, thus creating a structurally unemployed workforce in the UK.

Over the last decade manufacturing jobs have shifted from the US to countries like China where a cheaper labour force is available.

Fig 4

In today’s post Financial Crisis world, the menace of structural unemployment is dragging behind progress in not one or two but in most of the major world economies. In the US unemployment rose rapidly as an after-effect of the 2008 financial crisis and still lingers at an abnormally high rate of about 16%. The reasons include a rapid change in technology along with a dearth of retraining workers. Many cite a fall in the overall competitiveness of US students with those in the rest of the world as another reason. Some have simply been unemployed for so long that employers no longer wish to consider their candidature.

A similar trend is visible in Europe as well, which still hasn’t come out of its own crisis that started back in 2010. An illustration of the same can be seen in Figure 5. The figure stands at 21% for Spain, 10% for Italy, 7% for UK, and 9% for France.

This figure has seen an upward trend for most of Europe. The economic policies in major European countries have always favoured generous unemployment benefits, which is one of the reasons why workers have mostly been unwilling to get back to work. This situation has been worsened by the recent Euro Crisis.

Fig 6

Figure 6 is another illustration of how the risks of a Euro default and high unemployment may spread around the world.

Unemployment is directly co-related with income inequality. Events such as the Arab Spring in the Middle East, unrest in countries like Brazil and South Africa showed rising social unrest linked to income inequalities within these economies.

International systems of finance, supply chains, energy, health, the internet and the environment are becoming more complexly interdependent, and with this ever increasing inter-dependency the effects of a crisis such as this is often felt almost immediately over the rest of the world.

Conclusion

The risks identified above pose an ever greater danger to our social and economic fabric. Advanced economies like US and Japan look most vulnerable than ever, and certain developing economies are in the danger of creating further credit bubbles. These uncertainties in an increasingly multipolar world threaten to dislodge the world economy from the path towards progress, and reverse the advantages of an increasingly globalised world. The progress of strategically important sectors such as financial services, energy and healthcare is being threatened, and might decelerate to levels from which it might take decades to recover.

The need of the hour is collaborative action, opening up the lines of communication and greater transparency across the world. After the US Financial crisis there is a generation of young employable workforce known as The Lost Generation’ which sits under a huge pile of debt after paying for their education and with skills which are no longer in demand. The economic potential of this workforce lies idle and is in dire need of being tapped. Today as we enter 2014, four years after the financial crisis the situation remains grim, the progress remains slow. Economies remain trapped in policy paralysis, political brinkmanship, and other political/economic shibboleths which refuse to die down. Our generation faces the eminent danger of serious political/economic fallout if these risks are not addressed immediately and effectively.

The article has been authored by Shruti Sharma and Vasudeo Tewari, Birla Institute of Management Technology (BIMTECH)